Another Rally- Stocks Are On Fire

On Friday stocks had an across the board rally as all major indexes went up. The S&P 400, which is a mid cap index, hit an all-time high as it was up 0.5%. The S&P 500 outperformed the Nasdaq and Russell 2000 as it was up 0.31%. The S&P 500 was up 1.62% this week and is now up 3.94% on the year. It’s now just a few points away from the high made in March. It’s also only down 3.3% from the all-time high. While I tend to get more bearish as stocks rally, I think there will be great follow-through after the market makes a new record high. The great economic data, earnings data, and market breadth make me confident that this won’t be a double top. We’re close to my vision where the market rallies on the North Korean summit and it breaks new record highs.

Credit Markets Weaken

I mentioned previously that the financials and the consumer staples have been underperforming. On Thursday the financials had a great day and on Friday the consumer staples did well. The consumer staples were the best performing sector as they were up 1.3%. Even though the stock market was up, the CNN Fear and Greed index stayed at 62.

The chart below shows the equity market compared to the credit market. The recent volatility in Brazil hurt credit more than equities. The Brazilian index slipped further as it was down 1.24% on Friday. This is a big shift in sentiment as it was in a strong uptrend since January 2016. The dollar index was up 12 cents on Friday to $93.56. It’s interesting to see emerging markets falter even as the dollar’s modest rally has tapered off. The dollar index is only up $1.02 to $93.56 in the past month. The weakness in the past week has certainly helped the S&P 500.

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Curve Steepens

Even though the credit market has seen selling off this week, indicating ‘risk off’, the U.S. treasury market saw yields increase, indicating ‘risk on’ just like stocks. The 10 year yield increased 2.57 basis points to 2.95%. The best case scenario for the 10 year yield would be for it to increase modestly. Increasing too much would cause riskier bond yields to rise, potentially causing borrowing to decrease. If the yield falls, the curve will invert. It’s doubtful the 10 year treasury yield will rally too much because capital will come out of international bonds with lower yields and into the 10 year treasury, pushing its yield lower. Higher growth should push up yields slightly like we’ve seen.

The 2 year yield only increased 1 basis point, meaning the curve steepened. The latest difference is 45 basis points. The Fed’s decision to hike rates won’t have much of an effect on the markets, but a change in guidance would. I expect the Fed to reaffirm guidance for 3 hikes this year which would be modestly dovish since there’s a 38.6% chance the Fed raises rates at least 4 times. This would match the dovish Minutes which claimed rate hikes wouldn’t accelerate after the core PCE reaches 2%.

ECB About To End QE

Unlike the Fed which is in great shape as growth is accelerating and inflation is below 2%, the ECB is in terrible shape as it tries to end QE even as growth is faltering. Luckily, the Italian political crisis was avoided at least temporarily. However, the European economy is still slowing so it will be tough to eliminate all monetary stimulus. The chart below shows the new orders index for German manufacturing. As you can see, it has been falling, signaling GDP growth will fall as well. The German PMI fell from 58.1 to 56.9 in May. The services PMI also fell from 53 to 52.1. I’ll be looking for improvement in European economic growth, but it’s not here yet.

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Hopefully, the economic growth picks up in the next few months because the ECB is expected to begin formal discussions about winding down QE at its June 14th meeting. The futures market now expects a 10 basis point hike in September 2019. Clearly, these traders don’t expect the current weakness to become something greater.

The chart below shows the core inflation is only 1.1% which isn’t close to the 2% goal. The overall inflation is at 1.9% because of rising oil prices. However, in the past few weeks oil prices have stabilized, so that 1.9% rate is not sustainable.

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ECRI Estimate Update

The weekly leading index saw growth fall again this week. It’s down from 3% to 2.6%. Clearly, this leading index is seeing something that’s not in the data I look at. If you follow this index, then you should expect growth deceleration in the 2nd half of the year. I wouldn’t recommend selling until the stock market reflects the current great growth. Economic growth and earnings aren’t always in tune with the market. For example, when stocks declined in February, some said investors were worried about 2019 results. At that point, bad results are priced in, so there was no point in selling then. I wouldn’t sell the S&P 500 now because Q2 is the economic growth peak since the S&P 500 isn’t also at a peak. You need to figure out what is priced in before making a knee jerk reaction.

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Conclusion

One other point on GDP growth peaking is that if GDP growth is above 3.1%, then this will be the first time in history growth increases 8 straight quarters. Saying growth won’t continue moving higher for the rest of the year isn’t exactly a major call. Predicting the stock market will peak this quarter would be a major call. This isn’t what the investment banks are expecting besides a few bearish ones.

This week is one of the biggest of the year because of the Fed meeting, ECB QE discussions, and the North Korean summit. Unlike this week, there could be volatility. Ultimately, I think everything will work out and we’ll challenge the all-time high in the S&P 500.